The ChoosaBroker Trading Academy
Portfolio Management Theory
Most successful investors don’t put all their eggs in one asset basket. They realize that financial markets are uncertain, and the ideal approach would be to spread the risk across multiple instruments. Since different investments exhibit different risk-reward profiles, their relative composition in a portfolio is decided by a whole host of factors. Portfolio management streamlines this entire process of selecting and balancing an investor’s asset index so that his or her short-term and long-term financial objectives are achieved. In this lesson, we will learn:
What is Portfolio Management?
Portfolio management is defined as the art and science of selecting and managing a catalogue of financial assets in order to meet specified goals that benefit the participating investor. An investment portfolio comprising of assets that yield a maximum return for a given level of risk, or minimum risk for an expected return level, is termed as an “efficient portfolio”. Thus, investors, through portfolio management, strive to maximize their expected return, taking in to consideration their individually acceptable risk appetite.
Objectives of Portfolio Management
An “efficient portfolio” has multiple objectives and strikes a healthy balance among each one of those components. Listed below are some of the key objectives of an ideal portfolio management process.
- Safety of Principal – This is the foremost objective of most investors. Safety involves not only keeping the investment principal intact but also keeping intact its purchasing power. Other factors like income or growth should come in to consideration only after the safety of investment has been taken care of.
- Stability of Income – Once investment safety has been accounted for, the next major objective is to ensure that the portfolio generates a steady income stream that is big enough to compensate for the opportunity cost of the invested funds.
- Capital Appreciation – A good portfolio should appreciate in value so as to shield the investor against any erosion in real value after adjusting for inflation.
- Diversification – Another one of the basic objectives of a portfolio is to reduce the risk of capital loss by investing in a diverse mix of unrelated financial instruments.
- Marketability – If a portfolio consists of illiquid assets, an investor may face problems in case he or she wants to sell them off, or switch from one instrument to another. Investing in actively-traded assets provides flexibility to a portfolio.
- Liquidity – Any portfolio should have enough funds available at short notice so that investors’ liquidity requirements can be met immediately.
- Favourable Tax Status – The effective yield of an investor depends on the taxes to which the investments are subject. By minimizing the tax load, the yield can be improved. A portfolio should be so constructed that not only income tax, but also capital gains tax and gift tax are taken in to consideration.
Portfolio Management Process
Efficient portfolio management is a dynamic, continuous process that involves the following basic steps:
The portfolio management process begins with the outlining of a policy statement. It is like a road-map for the investor, whereby his or her investment objectives, preferences and constraints are drafted.
In the next stage, an investment strategy is developed that best caters to the investor’s needs and goals, as defined in the policy statement.
The strategy is then put to work by investing in a mix of assets that will not only minimise the investor’s risk but also meet the income or growth targets specified in the policy statement.
An investor’s objectives can change with time; so can underlying financial market conditions; making it important to monitor and update a portfolio to adjust for the changes that have come about.
Markowitz’s Modern Portfolio Theory
American economist Harry Markowitz received a Nobel Prize in 1990 for his path-breaking work on investment management that laid the foundation of the Modern Portfolio Theory.
Contemporary portfolio managers understand that there is no such thing as the “perfect investment.” They instead focus on creating a strategy that generates high returns with relatively low risk. While this premise seems rather straightforward today, such a strategy didn’t actually exist until the second half of the 20th century.
In 1952, Markowitz published an essay titled “Portfolio Selection” in “The Journal of Finance,” which demonstrates that investors can limit the volatility in their portfolios while simultaneously improving their performance by distributing the risk among different categories of assets that don’t always behave in the same manner.
A very basic principle of investing is that higher the risk, the higher should be the potential return, and vice-versa. According to the Modern Portfolio Theory, a combination of individual investment assets in a portfolio exhibit risk-return attributes that is based on the correlation of the components assets among each other. For each defined level of risk, there exists an “optimal” asset allocation that is constructed in such a way that it produces the best balance between risk and return. Markowitz states that an optimal portfolio will generate neither the highest return, nor will it display the lowest risk of all possible asset combinations. The optimal portfolio will in fact try to strike a balance between the highest return for an acceptable level of risk and the lowest risk for a given level of return. This meeting point of each risk-reward level is termed as the “Efficient Frontier,” and forms the core of the Modern Portfolio Theory.
Let us try to simplify the complex-sounding above postulate through an example. A “rational investor” is asked to pick between two instruments – X and Y. Both are expected to increase in value by 10% each year. However, Instrument Y is reckoned to be twice as volatile as Instrument X, meaning its price fluctuates twice as much as that of Instrument X. Given the above considerations, the Modern Portfolio Theory states that the “rational investor” will always select the less volatile asset, in this case Instrument X, so long as both produce similar returns.
Different Portfolio Management Strategies
There are four broad categories of portfolio management strategies. Let us examine each one of them.
- Active Management – It depicts a portfolio management style where the investment manager buys and sells shortlisted assets with the goal to outperforming a benchmark index. Typically, active asset managers exploit market inefficiencies by purchasing assets that are considered to be undervalued or by short selling instruments that are deemed overvalued. Depending on prevalent market regulations, either of these techniques may be used alone or in conjunction.
- Passive Management – It is the opposite of active management. Proponents of passive management believe in the efficient market hypothesis, which states that at all times markets absorb and reflect all relevant information, rendering individual asset-picking futile. Passive managers deduce that the best investing strategy is to put money in surrogates for market portfolio (index funds). These not only provide good asset diversification, but also result in lower turnover as well as management costs.
- Discretionary Management – In this portfolio management strategy, a qualified, professional asset manager invests on behalf of the clients. After taking an investor’s return expectation, risk profile and time horizon into account, the asset manager has the “discretion” to adopt whichever strategy he or she thinks is best-suited to meet the client’s objectives given the current market conditions. Most discretionary managers charge an assets-under-management fee for the services rendered.
- Non-Discretionary Management – In non-discretionary management, the clients make all the investment decisions. The managers are merely financial counsellors. They advise investors on the various available investment routes, clearly outlining the respective pros and the cons. The investors then assess the different options and choose their own path. Only once the investors give a go ahead to the managers can they buy and sell securities on behalf of the clients.
The portfolio management process offers an individual with an investment plan that takes in to account his or her age, income, free capital and ability to undertake risk. Since not every investor is equipped with adequate knowledge and time to undertake this rather elaborate task, a large number of individuals seek the help of professional portfolio managers to increase the odds of reaching their investment goals.